Friday, March 21, 2008

O'Neil's Exception to the 20% Profit Target, Part 1

In his book, How to Make Money in Stocks, William O’Neil advocates the use of a 20% profit target with one caveat.

“If a stock was so powerful that it vaulted 20% in less than eight weeks, the stock had to be held at least eight weeks.” Third edition, page 103.

He goes on suggest that after eight-weeks, we analyze the stock for a longer term gain but offers very few specifics on how this is to be done. More on this in the future.

If we think about this for a second, it means that the 20% profit target only becomes active after eight weeks (40 trading days) because if it reaches the price target before that, we do not exit until our time threshold has expired. The benefit this stop has is that if the stock’s movement is particularly strong, we allow our winner to run beyond the 20% target. As the previous couple of studies have illustrated, this is a critically important concept. The eight week period smells a little arbitrary but we will accept it for now and implement this concept in the following way:

If BarsSinceEntry >= 40 Then Exit with Limit Order at EntryPrice * 1.2

As in the previous tests, we will use the Stockbee IBD200 breakout entry on our 300 stock IBD basket and then use the Nasdaq and S&P components to confirm our results. All tests will also implement an 8% protective stop in addition to the profit-taking stop being tested.

8% protective + 20% Profit Target Only

These are the results from the earlier set of tests I am repeating here for ease of comparison.

So we can see that this implementation of Mr. O’Neil’s exception to the 20% profit target is an effective strategy to let our winners run. The simple addition of this time threshold has elevated our expectancy per dollar risked by 48% in our IBD basket, 101% in our Nasdaq basket, and 41% in our S&P500 basket. Part 2 will extend this study through a different interpretation of Mr. O’Neil’s suggestion, as a Rate of Change (ROC) stop.

The 8% protective stop is fixed. The "case for multiple entries, part1" used an 8% trailing in one of the tests and you can read about that there. I don't want to take the liberty of sharing the details of the Stockbee entries here but it is basically a percentage breakout with volume and recent weakness criteria.